Federal and State Tax on Treasury Bond Interest

Federal income tax applies to Treasury bond interest, but state and local governments cannot tax it — a privilege that reduces after-tax yield and matters most to residents of high-tax states. Interest from T-bills, notes, and bonds all follow this rule, though they are reported differently.

Federal Income Tax Always Applies

Treasury interest is ordinary income under federal law. If a Treasury bond pays 4% annual coupon or a T-bill is purchased at discount, the interest portion is subject to federal income tax at your marginal rate — whether you are in the 10% bracket or the 37% bracket. No exemption exists at the federal level, no matter your income or filing status.

This is why a Treasury bond yielding 4% is not equivalent to a taxable corporate bond also yielding 4%. The Treasury bond’s after-tax yield is lower by your federal tax rate. For an investor in the 37% federal bracket, a 4% Treasury yield becomes 2.52% after federal tax.

State and Local Exemption

In the United States, states and municipalities cannot tax the interest from federal government securities. This exemption applies to all Treasury instruments—bills, notes, bonds, STRIPS, and inflation-adjusted TIPS. It is automatic and requires no special claim or filing.

The exemption is particularly valuable to residents of high-tax states. New York, California, and New Jersey impose marginal income tax rates of 10% or more. For a New York City resident, Treasury interest avoids roughly 6.85% (state) plus 3.876% (local) in additional tax, on top of federal. That 4% Treasury yield looks much better compared to a 4% corporate bond when state and local taxes are considered.

Federal law also makes clear that Treasury interest cannot be included in a state’s definition of taxable income. A few states attempted to work around this in the 1980s by taxing the capital gain on Treasury sales; courts struck down these schemes as violations of the supremacy clause.

Reporting T-Bills and Short-Term Discounts

T-bills and other Treasury securities sold at discount present a wrinkle. The difference between your purchase price and the redemption value (or sale price) is treated as interest. Unlike a coupon bond, no interest payment is made to you directly.

If you hold the T-bill to maturity, you report the discount as interest income in the year of maturity, typically on Form 1099-INT. Your broker automatically reports it.

If you sell the T-bill before maturity, the treatment is different. The gain (proceeds minus cost basis) is split into accrued interest and capital gain. The accrued-interest portion is reported as ordinary interest income. The remaining gain or loss appears on Schedule D as a short-term or long-term capital gain or loss, depending on your holding period.

Coupon Bonds and Form 1099-INT

Treasury bonds and notes paying semi-annual coupons are reported on Form 1099-INT in the year you receive the coupon, not in the year of purchase. The 1099-INT shows the full coupon amount received, regardless of whether you owned the bond for the entire coupon period.

If you buy a Treasury bond between coupon dates, the seller will have accrued some interest that should have been paid to them. You reimburse the seller (accrued interest), then receive the full next coupon. When you file, you adjust your interest income on Schedule A or directly on your return to avoid double-counting — you reduce reported interest by the accrued interest you paid at purchase. This prevents the seller’s income and your income from overlapping.

Original Issue Discount and Annual Accrual

Treasury STRIPS and zero-coupon bonds have no coupon; they are sold at deep discounts and redeemed at par value. The difference is original issue discount (OID). Federal tax law requires you to report OID accrual annually as interest income, even though you receive no cash until maturity or sale.

The IRS provides OID tables (or your broker calculates) how much OID to accrue each year. This is mandatory — you cannot defer recognizing the income until maturity. If you buy a STRIP and hold it five years before selling, you have already paid tax on all five years of accrued interest, even though you received zero cash from the security itself.

This annual accrual requirement makes STRIPS, despite their tax-exempt state treatment, a less tax-efficient choice for residents in high-tax states compared to coupon bonds, because you are forced to pay federal tax on phantom income while waiting for maturity.

Interaction with Tax Brackets and Phase-Outs

Treasury interest is included in your adjusted gross income, which can affect other tax calculations. Higher interest income may:

• Push you into a higher tax bracket.
• Reduce eligibility for credits (education, child tax, earned income).
• Trigger Alternative Minimum Tax if your alternative minimum taxable income exceeds the threshold.
• Increase the taxable portion of Social Security benefits if you are claiming them.

A $50,000 Treasury yield might add $3,000 to your federal tax bill outright, plus indirectly cost you $1,000 in lost credits or higher taxation of benefits. This is why, when modeling retirement income, tax-exempt municipal bonds are sometimes preferable to Treasuries, despite lower yields.

Loss Harvesting on Treasury Securities

You can sell a Treasury security at a loss and claim a capital loss on Schedule D. This loss offsets capital gains (up to $3,000 per year against ordinary income) and carries forward indefinitely.

However, wash-sale rules apply. If you sell a Treasury bond at a loss, you cannot buy the same or substantially identical bond within 30 days before or after the sale. The IRS interprets Treasury securities strictly: a bond maturing in 2030 is not substantially identical to a bond maturing in 2031, so you can swap bonds on different maturity dates. But buying back the exact same CUSIP within 30 days triggers the wash-sale rule, disallowing the loss.

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